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Enterprise Valuation
Overview
In this chapter we review the basics of business, or enterprise,
valuation. Our focus is on the
hybrid valuation approach that combines DCF analysis (discussed
in Chapters 2-5) with
relative valuation (introduced in Chapter 6). We decompose the
enterprise valuation problem
into two steps: The first step involves the valuation of a
business's planning period cash flows
spanning a 3- to 10-year period, and the second step involves
the calculation of the terminal
value, which is the value of all cash flows that follow the
planning period. Pure DCF
valuation models use DCF analysis to analyze the value of the
planning period and terminal
value cash flows, whereas the hybrid valuation model we discuss
utilizes DCF analysis to
value the planning period cash flows and an EBITDA multiple to
estimate the terminal value.
7.1 INTRODUCTION
In this chapter we focus our attention on what is generally
referred to as enterprise valuation,
which is the valuation of a business or going concern. The
approach that we recommend,
which we refer to as the hybrid approach, recognizes that
forecasting cash flows into the
foreseeable future poses a unique challenge since most
enterprises are expected to stay in
business for many years. To deal with this forecasting problem,
analysts typically make
explicit and detailed forecasts of firm cash flows for only a
limited number of years (often
referred to as the planning period) and estimate the value of
all remaining cash flows as a
terminal value, at the end of the planning period.
The terminal value can be estimated in one of two ways. The
first method is a
straightforward a application of DCF analysis using the Gordon
growth model. As we
discussed in earlier chapters, this approach requires an
estimate of both a growth rate and a
discount rate. The second method applies the multiples approach
we discussed in the last
chapter; typically, the terminal value is determined as a
multiple of the projected end of
planning period earnings before interest, taxes, depreciation,
and amortization (EBITDA). When this latter approach is used to
evaluate terminal value and DCF is used to evaluate the planning
period cash flows, the model is no longer a pure DCF model but
becomes a hybrid approach to enterprise valuation.
The enterprise valuation approach described in this chapter is
used in a number of
applications. These include acquisitions, which we consider in
the example highlighted in
this chapter; initial public offerings, where firms go public
and issue equity for the first time,
which we described in the previous chapter. Going private
transactions (which we will
consider in the next chapter); spin-offs and carve-outs (where
the division of a firm becomes
a legally separate entity); and finally, the valuation of a
firms equity for investment
purposes.
In most applications, analysts use a single discount rate-the
weighted average cost of
capital (or WACC) of the investment-to discount both the
planning period cash flows and the
terminal value. This approach makes sense if the financial
structure and the risk of the
investment are relatively stable over time. However, analysts
frequently need to estimate the
enterprise value of a firm that is experiencing some sort of
transition, and in these cases the
firms capital structure is often expected to change over time.
Indeed, firms are often
acquired using a high proportion of debt, which is then paid
down over time until the firm
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reaches what is considered an appropriate capital structure. In
these cases, the assumption of
a fixed WACC is inappropriate, and we recommend the use of a
variant of the discounted
cash flow model known as the adjusted present value model, which
we describe later in this
chapter.
Finally, it should be noted that when firms acquire existing
businesses, they typically
plan on making changes in the businesss operating strategy. This
requires that the potential
acquirer value the business given both its current strategy as
well as the proposed new
strategy. Valuing the current strategy can be viewed as a
reality check-if the business is not
valued appropriately given its current strategy, why not? One
could then value scenarios
where the firms operating strategy is changed following the
acquisition to determine whether
the new strategy creates additional value. To help answer this
question, sensitivity analysis
can be deployed to determine the situations in which this
additional value is indeed realized.
The chapter is organized as follows: Section 7.2 introduces the
notion of estimating a
firms or business units enterprise value using the
hybrid/multiples approach. Section 7.3
introduces the adjusted present value (APV) model, which is an
alternative model that does
not require that the firms capital structure remain constant
over the foreseeable future.
Finally, we close our discussion of enterprise valuation with
summary comments in Section
7.4.
7.2 USING A TWO-STEP APPROACH TO ESTIMATE ENTERPRISE VALUE
We noted in the introduction that forecasting firm cash flows
into the foreseeable
future is a challenging task, and for that reason analysts
typically break the future into two
segments: a finite number of years known as the planning period,
and all years thereafter.
(See the Practitioner Insight box. Enterprise Valuation Methods
Used on Wall Street).
Consequently, the application of the DCF model to the estimation
of enterprise value can best
be thought of as the sum of the two terms found in Equation 7.1.
The first term represents the
present value of a set of cash flows spanning a finite number of
years, referred to as the
planning period (PP).
PP Periodin Value
Terminal theof
ValuePresent
Term2
FlowsCash (PP) Period
Planning theof
ValuePresent
Term1ValueEnterprise
The second term is the present value of the estimated terminal
value (TVpp) of the
firm at the end of planning period. As such, the terminal value
represents the present value of
all the cash flows that are expected to be received beyond the
end of the planning period. As
the following Technical Insight box on page 284 illustrates, the
terminal value estimate is
generally quite important and can often represent over 50% of
the value of the enterprise.
Example TATA Steel Ltd, Acquires Corus
To illustrate our enterprise valuation approach, consider the
valuation problem in Tata Steels
acquisition or Corus in February 2007. Tata Steel Ltd, the
largest steel company in India (5
million tons of steel), has often been cited as the lowest-cost
producer of steel in the world. It
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enjoys EBITDA margins of 30%-40%. Although Corus has been marred
by financial
problems and lags behind in production efficiency with EBITDA
margins of less than 10%,
the recent increase in global demand for steel has helped it
turn around.
As discussed in Chapter 1, the Corus acquisition fits into Tata
Steels overall business
strategy, which recognizes that the steel industry has undergone
a significant transformation
in recent times and tee I can no longer be viewed as a
homogeneous product. For instance,
Tata Steel specializes in the production of steel slabs, an
intermediate form of steel because it
is closer to the source of raw materials (iron ore mines). In
contrast, Corus: has a
comparative advantage in producing customized steel, which is a
key requirement in several
industries (especially the automobile industry). Customized (or
finished) steel can be sold at
a premium compared to steel slabs because of significant
value-addition. Tata Steels overall
business strategy differentiates between steel slab capacity and
finished steel capacity. It
involves acquiring each form of capacity in those geographic
locations which offer the best
potential for value creation. The Corus acquisition highlights
this aspect of their overall
business strategy.
The acquisition cost of 6172.31 million is 8.31 times Coruss
2006 EBITDA of 743
million (see Table 7.1). The acquisition cost of 6172.31 million
along with a net debt
amount of 1798 million1, implies an enterprise value (EV) of
7970.31 million. Adjusting
for cash of 823 million, the EV/EBITDA ratio is 9.62. However,
the standard metric for
valuation in the steel industry is EV per ton of steel. Corus
produces about 18 million tons of
steel. This implies an EV of 397 per ton, or $767 per ton of
steel (at the prevailing
exchange rate at the time of the transaction), which is close to
the average of $747 per ton for
similar transactions in the recent past.
1 Liabilities in Corus include long-term debt and other
obligations in the form of deferred tax
liabilities and pension liabilities. However, a major portion of
the 1798 million liability is
in the form of long-term debt. In the interest of keeping the
analysis as simple as possible, we
treat the entire liability amount of 1798 million as long-term
debt.
PRACTITIONER INSIGHT:
Enterprise Valuation Methods Used on Wall Street - An Interview
with Jeffrey Rabel*
In broad brush terms there are three basic valuation
methodologies used throughout the
investment banking industry: trading or comparable company
multiples, transaction
multiples, and discounted cash flows. Emphasis on a particular
methodology varies
depending on the particular setting or type of transaction. For
equity transactions such as the
pricing of an initial public offering (IPO), relative valuation
based on multiples of market
comparables (firms in the same or related industries, as well as
firms that have been involved
in recent similar transactions) is the preferred approach. The
reason for the emphasis on this
type of valuation is that the Company will have publicly traded
equity and thus investors will
be able to choose whether to buy said Company or any of the
other companies that are
peers.
A key consideration in relative valuation analysis is the
selection of a set of
comparable firms. For example, in the Hertz IPO we looked at not
only the relative prices of
car rental firms (Avis, Budget, etc.) but also considered
industrial equipment leasing
companies (United Rental, RSC Equipment, etc.) since this was a
growing piece of Hertzs
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business model. We also looked at travel related companies, as a
large part of the Hertz
rental car business is driven by airline travel. Some also
believed that Hertz, because of its
strong brand name recognition, should be compared to valuation
multiples of a set of
companies with strong brand recognition including firms such as
Nike or Coke. Obviously
selection of a comparable group of firms and transactions is
critical when carrying out a
relative valuation because different comparable sets trade at
different multiples and this
affects the valuation estimate.
In merger and acquisition (M&A) analysis involving a
strategic buyer (typically
another firm in the same or a related industry) or a financial
buyer such as a private equity
firm (see Chapter 8 for further discussion) the second type of
relative valuation method,
transaction multiples, is used in combination with discounted
cash flows (DCF). The reason
for the focus on a transaction multiple is the fact that
transaction multiples represent what
other buyers have been willing to pay for similar companies or
companies with related lines
of business. The transaction multiples are used in combination
with the DCF approach as
DCF allows the buyers to value the acquisition based on their
forecast of its performance
under their assumptions about how the business will be run.
DCF valuation methods vary slightly from one investment bank to
another: however,
the typical approach to enterprise valuation is a hybrid
approach consisting of forecasting
cash flows to evaluate near-term projections and relative
valuation to estimate a terminal
value. The analysis typically involves a five-year forecast of
the firms cash flows which are
discounted using an estimate of the firms weighted average cost
of capital. Then the value
of cash flows that extend beyond the end of the planning period
are estimated using a
terminal value that is calculated based on a multiple of a key
firm performance attribute such
as EBITDA. The terminal value estimate is frequently stress
tested using a constant growth
rate with the Gordon growth model to assess the reasonableness
of the implied growth rate
reflected in the terminal value multiple.
The final valuation approach we use a variant of the DCF
approach that is used where
a M & A transaction involves a financial sponsor (generally
a private equity firm such as
Blackstone, Cerberus or KKR. Financial buyers are primarily
driven by the rate of return
they earn on their investors money so the valuation approach
they use focuses on the IRR of
the transaction. The basic idea is to arrive at a set of
short-term cash flow forecasts that the
buyer is comfortable with, estimate a terminal value at the end
of the forecast period
(typically 5 years), and then determining IRRRs by varying the
acquisition price.
* Jeffrey Rabel is a CPA and a Vice President in the Global
Financial Sponsors group at
Lehman Brothers in New York.
The acquisition cost of 6172.31 million to acquire Corus was too
large an amount,
given the size of Tata Steel Ltd. The only feasible financing
alternative for Tata Steel Ltd,
was to raise a significant portion of the acquisition cost in
the form of debt. To safeguard the
interests of Tata Steels shareholders, the management of Tata
Steel had hinted at the time of
the acquisition that the acquired assets and the associated debt
would be placed in a separate
legal entity. This arrangement would effectively protect Tata
Steels shareholders from the
risks associated with high debt. For the purpose of acquiring
Corus, Tata Steel therefore
created a wholly owned subsidiary in the U.K. (Tata Steel
Limited).
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Table 7-1 Pre-and Post-Acquisition Balance Sheets for Corus (All
Figures in Millions)
Pre-Acquisition
2006
Post-Acquisition
2006
Current Assets*
Net property, plant, and equipment
Other investments and assets
Goodwill
4,412.00
2,758.00
780.00
130.00
4,412.00
2,758.00
780.00
2,368.31
Total
Current liabilities
Long-term debt**
8,080.00
2,348.00
1,798.00
10,3180.31
2,348.00
4,526.39
Total liabilities
Paid-up capital
Premium
Retained earnings
Common equity
Total
4,146.00
1,725.00
389.00
1,820.00
3,934.00
8,080.00
6,874.39
1,725.00
1,718.93
0.00
3,443.93
10,318.31
* 2006 and 2007 Current Assets include Cash of 823 million
** Long term loans and other long-term liabilities have been
clubbed together under the head
Long-term debt.
This type of transaction is a highly leveraged one and is
frequently used by private
equity groups or corporate raiders to take over undervalued
companies. We often hear about
such transactions-they go by the name of LBOs (leveraged
buy-outs). The Tata Corus
acquisition, however, does not fit into the category of a
standard private equity led LBO
transaction because Tata Steel has not entered into the
transaction with an explicit intent to
divest Corus at a higher valuation in the future. In contrast,
sponsors of LBO acquisition
strategies have very clearly defined goals of divesting the
acquired assets within a five-to ten-
year time frame. We will examine the more general use of LBOs as
part of an acquisition
strategy in Chapter 8.
Table 7.1 shows the pre- and post-acquisition balance sheets for
Corus. The
acquisition cost of 6172,.31 million reflects a premium of
2238.31 million above Coruss
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pre-acquisition book value of the equity of 3934 million. Note
that this difference is
recorded as goodwill in the revised post-acquisition balance
sheet.2
2 By including all of the purchase premium as Goodwill we are
assuming that the appraised
value of the Coruss assets is equal to their book value.
We assume that Tata Steel UK is able to raise 60% of the
acquisition cost of 6172.31
million in the form of long-term loans.3This amount is 3703.39
million. The long-term loans
come with legally structured agreements, which ensure that cash
flow from Coruss
operations will be used to service these loans. Second, we also
carry forward old debt in
the amount of 823 million.4This implies that the total debt
amount post acquisition is
4526.39. Given an enterprise value of 7970.31 million, it
follows that the remaining
amount of 3443.93 million has to be supplied by equity
holders.
In summary, post acquisition, Tata Steel UK and Corus
combination will have a total
of 7970.31 million in invested capital, of which 4526.39 million
(56.79%) is debt and the
remaining 3443.93 million (43.21%) is equity. Current
liabilities consist mostly of
payables, and therefore we treat this amount as a non-interest
bearing liability.
We can decompose the synergies in the acquisition into two
components. First, under
the new management, synergies arise in the operations of Corus.
These synergies would be
reflected in the value of Tata Steel UK. As an equity holder in
Tata Steel UK, Tata Steel Ltd
would therefore benefit from the synergies created in Corus.
Second, Tata Steel Ltd. could
directly experience synergies in its own operations as a result
of the Corus acquisition. The
valuation of the acquisition to Tata Steel should reflect both
sources of synergy. In this
chapter, however, we focus only on the former source of synergy,
i.e., we value the Corus
acquisition from the perspective of Tata Steel UK, rather than
Tata Steel Ltd. (India).
To estimate these synergies, we will first examine Corus prior
to the acquisition under
a status quo strategy. Then we will analyze the value of Corus
under a growth strategy
that reflects the restructuring plans of Tata Steel UK. The
comparison of the value of Corus
under these two strategies will help us estimate the synergies
created in Corus under the new
management.
Our analysis of the status quo strategy shows that Corus has an
enterprise value in the
range of 5 to 6 billion, which implies a share value in the
range of 350 to 400 pence a
share. This is consistent with the share price of Corus during
the six-month period prior to
the acquisition. Then we estimate the value of the growth
strategy that Tata Steel UK is
likely to display after the acquisition. We find that cash flows
under the growth strategy are
lower than those under the status quo strategy for the first few
years. However, in later years,
when the synergies of the acquisition start kicking in, the cash
flows arising from the growth
strategy become larger. We find that the enterprise value of
Corus under the management of
Tata Steel UK could be in the range of 9 to 11 billion,
depending on the method used for
valuation.
3The financing arrangement that was eventually adopted differed
a slightly from this rough
breakup. According to a press release of Reuters LPC (Tata Steel
launches 3.7 bln stg loan
for Corus buy, Friday July 6, 09:00 PM), the financing of Tata
Steel UK has been structured
as a hybrid corporate-leveraged financing arrangement and will
have no recourse to parent
company Tata Steel. The bankers to the deal are ABN AMRO,
Citibank, and Standard
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Chartered. The long-term loans amount to a total of 3670
million. The interest rates have
been set at LIBOR plus a spread ranging between 175 basis points
and 225 basis points.
Further the report mentions that Tata Steel and Tata Sons would
jointly invest 3500 million
as equity in Tata Steel UK. For our purposes, it makes sense to
value the investment
opportunity based on the expected financing arrangement rather
than the eventual financing
arrangement. At the time of making the acquisition offer, Tata
Steel had only ballpark
estimates of the terms of financing based on discussions with
their bankers. Our analysis is
therefore not constrained by this. lack of information.
4To keep matters as simple as possible, we assume that the old
debt that is carried forward
bears the same interest rate as the new debt.
Valuing Corus using DCF Analysis
We follow the same three-step procedure discussed in Chapter 2
to perform the DCF analysis
for valuing the Corus acquisition: Step 1-estimate the amount
and timing of the expected cash
flows; Step 2-estimate a risk-appropriate discount rate; and
Step 3-calculate the present value
of the expected cash flows, or enterprise value.
Step 1. Estimate the amount and timing of the expected cash
flows. We used information
gleaned from the annual reports of Corus prior to the
acquisition to evaluate the status quo
strategy. Corus was well on its way in implementing Restoring
Success, a key
restructuring initiative that had already resulted in
incremental EBITDA of 680 million by
the end of 2006. The hallmark of this initiative was to divest
from low-margin activities and
to consolidate in high-margin activities. As a result of such
restructuring activities,
significant cost reductions were achieved every year both in
terms of cost of goods sold and
general administrative expenditures. Going forward, we estimate
that the total savings would
be 150 million in 2007, 225 mi1lion during 2008-2009 and would
increase to 300
million annually during 2010-2012. These savings amount to 1500
million during the 2007-
2012 planning period. On C1l the expenditure side, Corus had
committed to renewing
employer contribution to pension schemes by an amount of 50
million annually from 2006.
We also assume that no extraordinary capital expenditures arise
in the status quo plan, other
than those required to offset depreciation.
The exact schedule of savings in costs and the additional
pension expenditures are
shown in Panel a of Table7-2. These estimates of savings are
reasonably conservative and
consistent with the stated plans of Corus management. Their
impact is more obvious when
we look at the projected change in EBITDA margin over the period
2007-2012. As can be
inferred from proforma income statements in Table 7.2 (and more
explicitly, in data stated in
Figure 7-1), these savings imply a relatively modest change in
EBITDA margins from 7.63%
in 2006 to 8.15% in 2012.
In Panel b of Table 7.2 we present the pro forma financial
statements and cash flow
projections for Corus that are required to complete Step 1 of a
DCF analysis. The cash flow
projections consist of planning period cash flows spanning the
period 2007-2012, and
terminal value estimates based on cash flow projections for 2013
and beyond. The pro forma
calculations reflect an assumed rate of growth in revenues of 3
% per year during the
planning period and a 1.5 % growth rate in firm free cash flows
in the post planning period.
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The asset levels found in the pro forma balance sheets reflect
the assets that Corus
needs to support the projected revenues. Current assets are
determined by a fixed current
asset-to-sales ratio of 45% (2006 actual), and current
liabilities are determined by a fixed
current liabilities-to-assets ratio of 29% (2006 actual). Any
additional financing requirements
are assumed to be raised by first retaining 95% of Coruss
earnings (implying a dividend
payout ratio of 5%) and then taking recourse to long-term debt.
A quick review of the pro
forma balance sheets found in Panel b of Table 7-2, however,
indicates that under the status
quo strategy Coruss long-term debt actually declines from 1798
million at the end of 2006
to 186.50 million by 2012. This decrease reflects the fact that
the firms retention of future
earnings is more than adequate to meet its financing needs,
which allows the firm to retire its
long-term debt. Finally, Coruss estimated cash flows, found in
Panel c, indicate that from
2007 through 2012 cash flows are expected to grow from 276.67
million to 438.87 million.
Estimating Coruss Enterprise Value using DCF Analysis (Status
quo Strategy)
[All Figures in Millions]
Panel a. (Step 1) Estimate the Key Savings in Costs and
Additional Expenditures
During Planning Period
Planning Period Pro Forma Financial Statements
2007 2008 2009 2010 2011 2012 Total
Change
(2007-
2012)
Reduction in
COGS
Reduction in
SG & A
Total Savings
Increase in
Pension
10%
90.00
10.00%
60.00
150.00
50.00
15%
135.00
15.00%
90.00
225.00
50.00
15%
135.00
15.00 %
90.00
225.00
50.00
20%
180.00
20.00 %
120.00
300.00
50.00
20%
180.00
20.00 %
120.00
300.00
50.00
20%
180.00
20.00 %
120.00
300.00
50.00
100%
900.00
100.00 %
600.00
1,500.00
300.00
Panel b. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Planning Period Pro Forma Balance Sheet
Corus Pro Forma Balance Sheets
2006 2007 2008 2009 2010 2011 2012
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Current
assets
4,412.00
4,544.36
4,680.69
4,821.11
4,965.74
5,114.72
5,268.16
Net
property-
plant, and
equipment
2,758.00
2,758.00
2,758.00
2,758.00
2,758.00
2,758.00
2,758.00
Other
investments
and assets
780.00
780.00
780.00
780.00
780.00
780.00
780.00
Goodwill 130.00
130.00 130.00 130.00 130.00 130.00 130.00
Total
8,080.00
8,212.36
8,348.69
8,489.11
8,633.74
8,782.72
8,936.16
Current
liabilities
2,348.00
2,386.46
2,426.08
2,466.89
2,508.91
2,552.21
2,596.79
Long-term
debt
1,798.00
1,641.98
1,420.67
1,181.08
872.30 541.18 186.50
Total
liabilities
4,146.00
4,028.44
3,846.75
3,647.96
3,381.22
3,093.38
2,783.30
Paid-up
capital
1,725.00
1,725.00
1,725.00
1,725.00
1,725.00
1,725.00
1,725.00
Premium 389.00 389.00 389.00 389.00 389.00 389.00 389.00
Retained
earnings
1,820.00
2,069.92
2,387.94
2,727.15
3,138.53
3,575.33
4,038.86
Common
equity
3,934.00
4,183.92
4,501.94
4,841.15
5,252.53
5,689.33
6,152.86
Total
8,080.00
8,212.36
8,348.69
8,489.11
8,633.74
8,782.72
8,936.16
Continued
Table 7-2 Planning Period Pro Forma Income Statements
Corus Pro Forma Income Statements
2006 2007 2008 2009 2010 2011 2012
-
Revenue
9,733.00
10,024.99 10,325.74
10,635.51
10,954.58
11,283.21
11,621.71
Cost of goods
sold
-
6,275.00
- 6,325.99 - 6,473.47 - 6,671.73 - 6,380.93 - 7,041.26 -
7,257.90
Gross profit
3,458.00
3,699.00 3,852.27 3,963.78 4,123.65 4,241.96 4,363.82
General and
administrative
expense
-
2,715.00
- 2,997.50 - 3,057.72 - 3,150.65 - 3,216.37 - 3,314.96 -
3,416.51
EBITDA 743.00 701.50 -794.54 813.13 907.27 926.99 947.30
Depreciation
expense
- 286.00 - 275.80 - 275.80 - 275.80 - 275.80 - 275.80 -
275.80
Net operating
income
457.00 425.70 518.74 537.33 631.47 651.19 671.50
Other income 58.00 58.00 58.00 58.00 58.00 58.00 58.00
EBIT 515.00 483.70 576.74 595.33 689.47 709.19 729.50
Interest expense - 202.00 - 107.88 -- 98.52 - 85.24 - 70.86 -
52.34 - 32.47
Earnings before
taxes
313.00 375.82 478.23 510.09 618.61 656.85 697.03
Taxes - 119.00 - 112.75 - 143.47 - 153.03 - 185.58 - 197.06 -
209.11
After-tax profit
from continuing
operations
194.00 263.07 334.76 357.06 433.03 459.80 487.92
After-tax profit
from
discontinued
operations
35.00
Net Income 229.00
Table 7.2 Continued
Panel c. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Planning Period Projected Firm Free Cash Flows (FFCF)
Projected Firm Free Cash Flows
2007 2008 2009 2010 2011 2012
EDIT 483.70 576.74 595.33 689.47 709.19 729.50
Less: Taxes - 145.11 - 173.02 - 178.60 - 206.84 - 212.76 -
218.85
-
NOPAT 338.59 403.72 416.73 482.63 496.44 510.65
Plus:
Depreciation
275.80
275.80
275.80
275.80
275.80
275.80
Less: Capex - 275.80 - 275.80 - 275.80 - 275.80 - 275.80 -
275.80
Less:
Increases in
Net
Working
Capital
- 61.92
- 63.78
- 65.69
-67.66
- 69.69
- 71.78
Equals
FFCF
276.67 339.94 351.04 414.97 426.74 438.87
Panel d. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Terminal Value Cash Flow Estimate
Method #1 DCF Using the Gordon Growth Model Ration -
Terminal Value Multiples from the Gordon Model
Growth Rates (g)
Discount Rates 0.00% 1.00% 1.50% 2.00%
8.357% 11.97 13.73 14.80 16.05
8.857% 11.29 12.86 13.80 14.88
9.357% 10.69 12.09 12.92 13.87
9.857% 10.15 11.40 12.15 12.98
Terminal Value Estimates (for FFCFs received in 2013 and
beyond)
Growth Rates (g)
Discount Rates 0.00% 1.00% 1.50% 2.00%
8.357% 5,251,77 6,025.31 6,496.70 7,042.24
8.857% 4,955.28 5,641.86 6,055.14 6,528.70
9.357% 4,690.48 5,304.29 5,669.79 6,084.97
9.857% 4,452.55 5,004.84 5,330.55 5,697.72
-
Method #2 Multiples Using Enterprise Value to EBITDA
Terminal Value Estimates
Enterprise Value / EBITDA Terminal Value
5.00
5.50
6.00
6.70
7.20
5,026.51
5,529.16
6,031.82
6,735.53
7,238.18
(Continued)
Panel e (Step 2) Estimate a Risk Appropriate Discount Rate
Cost of debt Estimated borrowing rate is 6.0% with a marginal
tax of 30% results in
an after-tax cost of debt of 4.200%.
Cost of equity An average industry unlevered equity beta of .849
implies a levered
equity beta for Corus of 1.02 assuming a target debt ratio of
22% and a debt beta of
.255. Using the capital asset pricing model with a 10 year
government security yield
of 4.60% and a market risk premium of 5.50% produces an estimate
of the levered
cost of equity of 10.189%.
Weighted average cost of capital (WACC) Using the target debt to
value ratio of
22% the WACC is approximately 8.857%.
Panel f. (Step 3) Calculate the Present Value of Future Cash
Flows
Present Value of Expected Future Cash Flows
Terminal Value Enterprise Value
Discount
Rate
Planning
Period FFCF
Method #1 Method #2 Method #1 Method #2
7.857%
8.857%
9.857%
1,706.31
1,651.65
7,599.60
4,451.40
3,639.11
3,302.60
4,278.50
4,048.02
3,831.90
6,157.70
5,290.76
4,632.20
5,984.80
5,699.67
5,431.50
Status Quo Strategy 2006 2007 2008 2009 2010 2011 2012
Total liabilities / Total assets 51.3% 49.1% 46.1% 43.0% 39.2%
35.2% 31.1%
Long-term debt/Total assets 22.3% 20.0% 17.0% 13.9% 10.1% 6.2%
2.1%
-
Growth Strategy Strategy 2006 2007 2008 2009 2010 2011 2012
Total liabilities / Total assets 66.6% 67.7% 67.7% 66.7% 63.7%
59.2% 53.5%
Long-term debt/Total assets 43.9% 44.9% 44.9% 43.9% 40.9% 36.5%
30.8%
EBITDA margins
2006 2007 2008 2009 2010 2011 2012
Status quo case 7.63% 7.00% 7.69% 7.65% 8.28% 8.22% 8.15%
Growth strategy case 7.63% 5.35% 6.93% 8.22% 10.99% 12.68%
13.97%
Growth minus Status quo 0.00% -1.64% -0.76% 0.57% 2.70% 4.47%
5.82%
Terminal Values, Expected Growth Rates, and the Cost of
Capital
When estimating value using a planning period and a terminal
value, how much of the value
can be attributed to each of these components? To answer this
question, consider the
situation where a firms free cash flows are expected to grow at
a rate of 12% per year for a
period of five years, followed by a 2% rate of growth
thereafter. If the cost of capital for the
firm is 10%, then the relative importance of the planning period
cash flows and the terminal
value cash flows for different planning periods is captured in
the upper figure:
If the analyst uses a five-year planning period, then the
present value of the planning
period cash flows in this setting constitutes 27.45 % of the
value of the enterprise, leaving
over 72.55 % of enterprise value in the terminal value.
Similarly, if a three-year planning
period is used, then the terminal value constitutes 83.83% of
the enterprise value estimate,
leaving only 16.17% for the planning period. The key observation
we can make from this
analysis is that the terminal value is at least 50% of the value
for the firm for all commonly
used planning periods (i.e., three to 10 years).
The previous example was obviously a very high-growth firm. It
stands to reason,
then, that the terminal value may be less important for more
stable (low-growth) firms. It
turns out (as the lower figure indicates) that even for a very
low- and stable-growth firm
whose cash flows grow at 2% per year forever, the terminal value
is still the dominant
component of the enterprise value estimate for the typical
three- to 10-year planning period.
In this case where the firm has a constant rate of growth of 2%
per year for all years, a five
year planning period results in 31.45% of the enterprise value
coming from the cash flows in
the planning period, which leaves 68.55 % of enterprise value in
the terminal value.
The message is very clear. The analyst must spend significant
time estimating the
firms terminal value. In fact, even for a long (by industry
standards) planning period of 10
years, the terminal value for the slow-growth firm above is
still roughly half (47%) of the
firms enterprise value.
How important should the terminal value be to the enterprise
value of your firm? As
the examples weve used above suggest, the answer will vary with
the firms growth
prospects and the length of the planning period used in the
analysis. In general, terminal
-
value increases in importance with the growth rate in firm cash
flows and decreases with the
length of the planning period.
Panel d includes two analyses of the terminal value of COTUS
evaluated in 2012.
The first method (Method #1) uses the Gordon growth model
(introduced in Chapter 2) to
estimate the present value of the firm free cash flows (FFCFs)
beginning in 2013 and
continuing indefinitely. Specifically, we estimate the terminal
value in 2012 using Equation
7.2:
(g) RateGrowth Terminal )(k Capita ofCost
(g) RateGrowth Terminal1FFCFValue Terminal
WACC
20122012
To estimate the terminal value using this method, we assume that
the cash flows the firm is
expected to generate after the end of the planning period grow
at a constant rate (g), which is
less than the cost of capital (Kwacc) Recall from our discussion
of multiples in Chapter 6 that
Equation 7.2a can be interpreted as a multiple of FFCF2012 where
the multiple is equal to the
ratio of one plus the terminal growth rate divided by the
difference in the cost of capital and
the growth rate, i.e.:
Multiple Model
GrowthGordon x FFCF
gk
g1 FFCF Value Terminal 2012
WACC
20122012
In Panel d of Table 7-2 we report a panel of Gordon growth model
multiples that
correspond to a reasonable range of values of the discount rate
and rate of growth in future
cash flows. For example, for the cost of capital of 8.857% and a
1.5% terminal growth rate,
the multiple for terminal value based on the Gordon Growth
Model,
gk
g 1
WACC
,is 13.80.
Based on the estimated FFCF2012 of 438.87 million, this produces
an estimate of the
terminal value at the end of 2012 of 6055.14 million.
In addition to the DCF analysis of the terminal value, Panel d
of Table 7-2 provides
an analysis that uses EBITDA multiples (Method #2), as shown in
Equation:
MultipleEBITDA EBITDA Value
Terminal
x 20122012
Multiples ranging from 5 to 7 are reported in Panel d of Table
7-2. The average multiple for
similar transactions that have recently occurred in the steel
industry is 6.70.
Using this multiple of 6.70 times EBITDA2012 (which equals
1005.30) produces an
estimated terminal value for Corus in 2012 of 6735.53 million =
6.70 x 1005.30 million. It
should be noted that the EBITDA multiple and the free cash flow
multiple generate very
similar terminal value estimates when there are no extraordinary
capital expenditures or
investments in net working capital. If this were not the case,
the analyst would want to
double-check his or her assumptions and attempt to reconcile the
conflicting terminal value
estimates.
-
Step 2. Estimate a risk-appropriate discount rate. Under the
status quo strategy, we
compute the cost of capital for Corus based on a 22% debt to
enterprise value ratio (2006
actual). We assume that this 22% ratio is the target capital
structure under the status quo
strategy. We also assume that the cost of debt of 6%. Details
supporting the calculation are
provided in Panel e of Table 7-2. The analysis implies an
estimated cost of capital for Corus
of 8.857%.
Step 3. Calculate the present value of the expected cash flows,
or enterprise value. In Panel
f of Table 7-2 we estimate the enterprise value of Corus using
the free cash flow estimates
from Panel c and discounting them with the estimated cost of
capital for Corus from Panel e
plus and minus one percent-8.857% (the estimated WACC), 7.857%,
and 9.857%. The result
is an array of enterprise value estimates reflecting each of the
methods used to estimate the
terminal value and the range of cost of capital estimates. With
the 8.857% estimated cost of
capital, the estimate of enterprise value is in the range of
5,291 million to 5700 million.
These numbers imply that the owners equity is in the range of
3493 million to 3902
million, or equivalently 344 pence to 384 pence per share. The
actual market price of Corus
shares in the six-month period prior to the acquisition also
varied around this range.
Based on this analysis, we can see that the acquisition is not
worth pursuing at a cost
of 608 pence a share unless there are synergies that compensate
for the premium paid in the
acquisition. The acquisition, therefore, makes sense only if
Tata Steel is confident of making
changes in the operating strategy of Coruss business. As we
discussed in Chapter 1 and at
the beginning of this chapter, the Tata Steel-Corus combination
offers significant
opportunities of creating synergies. Tata Steel is one of the
lowest cost producers of slab
steel, which is a key raw material for customized steel products
sold by Corus. Corus will
thus be able to reduce its cost of goods sold. At the same time,
Corus will be in a position to
divest from its low margin plants (or at least reduce the scale
of such plants), thereby saving
on administrative expenses. In addition, Corus will be able to
gain access to the increasing
demand for customized steel products in the high-growth emerging
market of India.
Valuing Corus under Tata Steels Growth Strategy
To evaluate the Corus acquisition under the management of Tata
Steel, we repeat the earlier
analysis keeping in mind the synergies of the acquisition. The
results of this analysis are
contained in Table 7-3. Panel a shows that the potential savings
under the growth strategy
over the planning period (2007-2012) are 3000 million which is
twice the total savings
under the status quo strategy. However, it can also be expected
that Tata Steel UK will incur
more cash outflows due to capital expenditures under the more
ambitious growth strategy. In
addition to these costs. Tata Steel has also agreed to put more
resources into the pension
scheme at Corus. Projections related to these item are shown in
detail in Panel a of Table
7.3.
It should be noted that Tata Steel had very little surplus steel
slab capacity in 2006 but
was confident about increasing capacity in the next two to three
years. This meant that there
would be a gestation period of two or three years before the
synergies arising in Corus due to
lower cost steel slabs start having a significant effect. The
pattern of savings in Panel a of
Table 7-3 reflects this situation. These estimates of savings
are reasonably conservative and
consistent with the stated plans of Tata Steel. As can be
inferred from proforma income
statements in Table 7.3 (and more explicitly, in data stated in
Figure 7-1), these savings imply
-
a change in EBITDA margin from 7.63% in 2006 to 13.97% in 2012.
Tata Steel
management has often said that it would be able to increase
EBITDA margins in Corus up to
20%.
Panel b of Table 7-3 presents proforma financial statements
(2007-2012) for Corus
under the growth strategy. The growth strategy involves
increased capital expenditures on
upgrading and restructuring of manufacturing capacity.
Specifically, the plan calls for
spending an additional 50 million each year on aggressive
marketing plans and capital
equipment throughout the six-year planning period.
We predict that the combined effect of these actions is to
increase the planning period
rate of growth in sales to 5% per year, compared to only 3%
under the status quo strategy.
After achieving the higher target market share in 2012, capital
expenditures and marketing
expenditures are expected to return to the status quo levels,
and the expected rate of growth in
firm free cash flow for 2013 and beyond is assumed to be 2%,
slightly higher than the 1.5%
growth rate in. the status quo case.
Comparing the cash flow projections for the status quo strategy
found in Panel c of Table 7-2
with those or the growth strategy in Panel c of Table 7-3, we
see that the growth strategy has
the initial effect of reducing cash flows below status quo
levels for 2007-2009. However,
beginning in 2010 the growth strategy cash flows will exceed
those of the status quo strategy
(577 million for the growth strategy as compared with 415
million for the status quo
strategy). Moreover, for all subsequent years we expect the
growth strategy to maintain a
higher level of FFCF. As can be seen in Panel f of Table 7-3,
the enterprise value estimates,
are dramatically higher under the growth strategy than under the
status quo strategy. Using a
cost of capital of 8.420% (Panel e of Table 7-3), it can be
shown that the enterprise value is
11,037 million when the Gordon growth model is used to estimate
the terminal value and
9,754 million when a 6.7 times EBITDA multiple (the average
EBITDA multiple in recent
transactions) is used to estimate the terminal value. These
enterprise values imply a value of
614 ($1185) per ton of steel under the Gordon method and a value
of 542 ($1047) per ton
of steel under the EBITDA multiple approach. After subtracting
the long term debt of 1798,
the owners equity is equal to 9239 million and 7956 million
under Method # 1 and
Method # 2, respectively. Given the acquisition cost of 6172.31
million, the NPV of the
acquisition from the point of view of Tata Steel UK is 3067
million and 1784, respectively.
Table 7.3 Estimating Corus's Enterprise Value using Analysis
(Growth Strategy)
(All Figures in Millions)
Panel a. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Planning Period Pro Forma Financial Statements
2007 2008 2009 2010 2011 2012 Total
change
2007-
2012
-
Reduction in
COGS
2% 5% 10% 20% 28% 35% 100%
42.00 105.00 210.00 420.00 588.00 735.00 2,100.00
Reduction in
SG&A
2% 5% 10% 20% 28% 35% 100%
18.00 45.00 90.00 180.00 252.00 315.00 900.00
Total
savings
60.00 150.00 300.00 600.00 840.00 1,050.00 3,000.00
New capital
expenditures
50.00 50.00 50.00 50.00 50.00 50.00 300.00
Increase in
Pension
126.00 50.00 50.00 10.00 10.00 10.00 256.00
Panel b. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Planning Period Pro Forma Balance Sheet
Pre-
Acquisition
Post-
Acquisition
Pro Forma Balance Sheets
2006 2006 2007 2008 2009 2010 2011 2012
Current
assets
4,412.00 4,412.00 4,632.60 4,864.23 5,107.44 5,362.81 5,630.95
5,912.50
Net
property,
plant, and
equipment
2,758.00
2,758.00
2,808.00
2,858.00
2,908.00
2,958.00
3008.00
3,058.00
Other
investments
and assets
780.00
780.00
780.00
780.00
780.00
780.00
780.00
780.00
Goodwill 130.00 2,368.31 2,368.31 2,368.31 2,368.31 2,368.31
2,368.31 2,368.31
Total 8,080.00 10,318.31 10,870.54 10,588.91 10,870.54 11,163.76
11,787.27 12,118.82
Current
Liabilities
2,348.00 2,348.00 2,473.66 2,473..66 2,540.39 2,609.88 2,682.27
2,757.72
Long-term
debt
1,798.00 4,526.39 4,882.52 4,882.52 4,904.44 4,691.66 4,297.55
3,731.72
Total
liabilities
4,146.00 6,874.39 7,356.18 7,356.82 7,444.82 7,301.53 6,979.82
6,489.44
-
Paid-up
capital
1,725.00 1,725.00 1,725.00 1,725.00 1,725.00 1,725.00 1,725.00
1,725.00
Premium 389.00 1,718.93 1,718.93 1,718.93 1,718.93 1,718.93
1,718.93 1,718.93
Retained
earnings
1,820.00 0.00 - 22.91 - 70.43 275.01 723.67 1,363.52
2,185.45
Common
equity
3,934.00 3,443.93 3,421.01 3,514.36 3,718.93 4,167.59 4,807.45
5,629.38
Total 8,080.00 10,318.31 10,558.91 10,870.54 11,163.76 11,469.13
11,787.27 12,118.82
Planning Period Pro Forma Income Statements
Pre-
Acquisition
Post-
Acquisition
Pro Forma Balance Sheets
2006 2006 2007 2008 2009 2010 2011 2012
Revenue 9,733.00
9,733.00
10,219.65
10,730.63
11,267.16
11,830.52
12,442.05
13,043.15
Cost of goods sold - 6,275.00 - 6,275.00 -
6,498.58
-
6,762.60
-
7,000.99
-
7,151.53
-
7,362.11
-
7,612.62
Gross profit 3,458.00 3,458.00 3,721.07 3,968.03 4,266.18
4,678.99 5,059.94 5,430.53
General and
administrative
expense
- 2,715.00 - 2,715.00 -
3,173.90
-
3,224.19
-
3,340.15
-
3,379.16
-
3,484.61
-
3,607.95
EBITDA 743.00 743.00 547.18 743.84 926.03 1,299.83 1,575.32
1,822.59
Depreciation
expense
- 286.00 - 286.00 - 275.80 - 280.80 - 285.80 - 290.80 - 295.80 -
300.80
Net operating
income
457.00 457.00 271.38 463.04 640.23 1,009.03 1,279.52
1,521.79
Other income 58.00 58.00 58.00 58.00 58.00 58.00 58.00 58.00
EBIT 515.00 515.00 329.38 521.04 698.23 1,067.03 1,337.52
1,579.79
Interest expense - 202.00 - 202.00 - 362.11 - 380.67 - 390.60 -
392.35 - 375.33 - 343.80
Earnings before
taxes
313.00 313.00 - 32.73 140.37 307.63 674.68 962.19 1,235.99
Taxes - 119.00 - 119.00 9.82 - 42.11 - 92.29 - 202.40 - 288.66 -
370.80
After-tax profit
from continuing
operations
194.00 194.00 - 22.91 98.26 215.34 472.27 675.53 865.19
After-tax profit
from
discontinued
operations
35.00 35.00
Net Income 229.00 229.00
-
(continued)
Panel c. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Planning Period Cash Flow Estimates
Projected Firm Free Cash Flows
2007 2008 2009 2010 2011 2012
EBIT 329.38 521.04 698.23 1,067.03 1,337.52 1,579.79
less: Taxes - 98.81 - 156.31 - 209.47 - 320.11 - 401.26 -
473.94
NOPAT 230.57 364.73 488.76 746.92 936.27 1,105.85
Plus:
Depreciation
275.80 280.80 285.80 290.80 295.80 300.80
less: Capex - 325.80 - 330.80 - 335.80 - 340.80 - 345.80 -
350.80
less:
Increases in
Net Working
Capital
- 103.20 - 108.36 - 113.78 - 119.47 - 125.44 - 131.71
Equals FFCF 77.37 206.37 324.98 577.46 760.83 924.14
Panel d. (Step 1) Estimate the Amount and Timing of Future Cash
Flows
Terminal Value Cash Flow Estimate
Method #1 DCF Using the Gordon Growth Model
Terminal Value Multiples from the Gordon Model
Growth Rates (g)
Discount Rates 0.00% 1.00% 1.50% 2.00%
7.920% 12.63 14.60 15.81 17.23
8.420% 11.88 13.61 14.67 15.89
8.902% 11.21 12.72 13.68 14.74
9.420% 10.62 12.00 12.82 13.75
Terminal Value Estimates (for FFCFs received in 2013 and
beyond)
Growth Rates (g)
Discount Rates 0.00% 1.00% 1.50% 2.00%
-
7.920% 11,668.99 13,488.90 14,611.48 15,923.69
8.420% 10,976.02 12,579.90 13,555.68 14,683.45
8.920% 10,360.75 11,785.68 12,642.18 13,622.45
9.420% 9,810.79 11,085.78 11,844.02 12,704.45
Method #2 Multiples Using Enterprise Value to EBITDA
Terminal Value Estimates
Enterprise Value / EBITDA Terminal Value
5.00
5.50
6.00
6.70
7.20
9,402.95
10,343.24
11,283.53
12,599.95
13,540.24
Panel e (Step 2) Estimate a Risk Appropriate Discount Rate
Cost of debt Estimated borrowing rate is 8.0% with a marginal
tax of 30% results in
an after-tax cost of debt of 5.600%.
Cost of equity An average industry unlevered equity beta of .849
implies a levered
equity beta for Corus of 0.97 assuming a target debt ratio of
35% and a debt beta of
.618. Using the capital asset pricing model with a 10 year
government security yield
of 4.60% and a market risk premium of 5.50% produces an estimate
of the levered
cost of equity of 9.938%.
Weighted average cost of capital (WACC) Using the target debt to
value ratio of
35% the WACC is approximately 8.420%.
Panel f. (Step 3) Calculate the Present Value of Future Cash
Flows
Present Value of Expected Future Cash Flows
Terminal Value Enterprise Value
Discount
Rate
Planning
Period FFCF
Method #1 Method #2 Method #1 Method #2
8.420%
10.000%
12.000%
1,996.66
1,873.52
1,731.80
9,040.26
6,651.08
4,775.62
7,757.49
7,112.34
6,383.53
11,036.92
8,524.60
6,507.42
9,754.15
8,985.86
8,115.33
-
Since the growth strategy initially has lower cash flows than
the status quo strategy
but later generates much higher cash flows, its incremental
value will depend on the discount
rate that is used to evaluate the strategy. In Panel e of Table
7-3 we show that the cost of
capital for the growth strategy is 8.420%, which is slightly
lower than under the status quo
strategy (8.857%) because we assume a higher target capital
structure (debt to enterprise
value ratio of 35% versus 22% under the status quo strategy).
Although the cost of debt (8%)
is higher under the growth strategy, the net effect is a
slightly lower cost of capital.
However, the growth strategy is almost certainly more risky than
the status quo
strategy and should require a higher cost of capital. To
evaluate how a higher cost of capital
will affect the value of the growth strategy, Panel f of Table
7-3 presents alternative values of
the growth strategy cash flows where the cost of capital is as
high as 12%. Under the Gordon
growth method (Panel f, Table 7-3), the imputed enterprise value
of 6507 million is well
below the EV of 7970.31 million. The EBITDA multiple method,
however, yields an
enterprise value of 8115 million, which is slightly greater than
the EV of 7970.31.
Sensitivity Analysis
The acquisition of Corus is a risky endeavor just like any
investment proposal, so it is
important that we perform a sensitivity analysis of the
proposal. In this instance, we will
limit ourselves to the use of breakeven sensitivity analysis
although, as we illustrated in
Chapter 3, it is often helpful to construct a simulation model
based on making estimates
concerning the random nature of the key value drivers.
We consider three important value drivers for the Corus
acquisition under the growth
strategy: (i) to the cost of capital for the acquisition, (ii)
the planned increase in EBITDA
margins due to savings in costs of goods sold and administrative
costs during the planning
period and (iii) the terminal value multiple used to value the
post-planning period cash flows.
If there is a slump in global steel prices, the effect on EBTIDA
margins would be the same as
not realizing potential costs savings. Hence, item (ii) can be
viewed as a representation of two
alternative forms of risk-one due to risk in steel prices and
the other due to risk in realization
of potential cost savings. Both these factors can adversely
affect EBITDA margins. Finally,
in the risk analysis that follows we focus our attention solely
on the valuation that uses the
EBITDA multiple (Method #2) to estimate the terminal value.
Sensitivity analysis - Cost of Capital
The cost of capital, like all the value drivers, is always
estimated with some error. However,
in this instance we have another reason to be concerned about
the cost of capital estimate.
The growth strategy is a more risky strategy than the status quo
strategy, which means that
the growth strategy cash flows should require a higher discount
rate - but how much higher?
One approach we can take to addressing this issue is to explore
the importance of the
discount rate to the valuation of Corus under the growth
strategy. To do this, we can
calculate the internal rate of return (IRR) of the investment
and ask whether it is plausible
that the appropriate discount rate exceeds the IRR.
We calculate the IRR for the acquisition based on the projected
cash flows found in
Panel b in Table 7-3 (and a terminal value for 2012 equal to 6.7
times EBITDA2012) and the
7970.31 million in invested capital reflected in the asking
price. The result is an estimated
-
IRR of 12.36%. Consequently, if the higher cost of capital for
the riskier growth strategy
exceeds 12.36%, the acquisition should not be undertaken.
Although the appropriate
discount rate for this investment is likely to be higher than
the discount rate for the status quo
investment, it is quite unlikely that it exceeds 12.36%. In
Panel e of Table 7-3 we noted that
Coruss estimated equity beta was 0.97, which produced a cost of
equity of 9.938% and a
weighted average cost of capital of 8.420%. To generate a cost
of capital of 12.36%, Coruss
equity beta would have to rise to 2.07, which is highly
unlikely.
Sensitivity Analysis - EBITDA margins
Next we consider a breakeven sensitivity analysis of the
synergies of the acquisition that give
rise to savings in costs of goods sold and administrative
expenses. While we focus on cost
savings as the source of the increase in EBITDA margins over the
planning period, our
results on sensitivity to EBITDA margins can also be interpreted
as sensitivity to global steel
prices. Our analysis reveals that if the costs savings of 3000
million over the six-year
planning period drop to 2100 million the NPV of the acquisition
drops from 1783 million
to 52 million.5 For the acquisition to be positive NPV, the
savings in costs is a critical
factor. If the costs savings drop by more than 30% (from 3000 to
2100), the acquisition
becomes unviable.
Sensitivity Analysis - Terminal Value EBITDA Multiple
The final value driver we consider is the terminal value
multiple (i.e., enterprise value
divided by EBITDA) that is used to estimate the terminal value
of Corus in 2012. In our
earlier analysis we used a multiple of 6.70, which was the
average purchase price multiple in
similar transactions. However, if we reduce this terminal value
EBITDA multiple to 5.15, the
NPV of the acquisition for Tata Steel drops below zero.
Scenario Analysis
Up to this point we have considered three value-drivers (the
discount rate, the amount of cost
savings, and the EBITDA multiple at the terminal date one at a
time. This discussion
suggests that our conclusion about the attractiveness of the
investment is not likely to change
if we alter anyone of the value drivers individually. However,
there are scenarios in which all
three value-drivers differ from their expected values such that
the Corus investment does
have a negative NPV.
For example, although we argued that a 12.36% discount rate is
very unlikely, a 10%
discount rate is plausible. Similarly, one might assume that the
planning period cost savings
may be 2700 rather than 3000. If these changes are made, then
the terminal value
EBITDA multiple only has to drop to 6.22 times before the
enterprise value of Corus under
the growth strategy drops to a level that results in a negative
NPV project at the acquisition
cost of 6172.31 million. As the following table indicates, there
are a number of plausible
scenarios under which the acquisition and implementation of the
growth strategy might not
be value-enhancing. We present three such breakeven
scenarios.
Value Driver Initial
Parameters
Breakeven Scenarios Negative
NPV
Scenario
-
Scenario #1 Scenario #2 Scenario #3 Scenario #4
Cost of
Capital
8.420% 10.000% 10.066% 9.000% 10.000%
Cost Savings
during the
planning
period
3000
million
2700
million
2850
million
2589
million
2500
million
Terminal
value
EBITDA
multiple
6.70 times
6.218 times
6 times
6 times
6.40 times
We also present a negative NPV scenario. For example, with a
slightly less favorable
6.40 EBITDA multiple for our terminal value calculation the
acquisition has an enterprise
value of 7810 million (i.e., becomes a negative NPV investment)
if we combine this with a
just slightly less favorable assumption about the discount rate
(10%) but somewhat more
significant reduction in the cost savings for the planning
period (500 million less). As we
learned earlier in Chapter 3, reviewing likely but less
favorable scenarios, which can lead to a
negative NPV, is a very powerful tool for learning about a
projects investment potential.
The set of scenarios reviewed above are far from exhaustive, and
we can always find
scenarios under which almost any investment has either a
positive or negative NPV. What
this means is that the tools that we have developed are just
that-decision tools-they provide
support and background for the actual decision maker, but they
do not actually make the
decision. In this particular case, as is often true, the numbers
provide some justification for
whether or not Tata Steel should go ahead with the acquisition
of Corus. However, the
numbers also suggest that there are significant risks and the
success of the acquisition will
depend on how the future unfolds. This will generally be the
case-the tools provide
management with valuable information, but ultimately management
must use their judgment
to make the decision.
7.3 USING THE APV MODEL TO ESTIMATE ENTERPRISE VALUE
Up to this point we have been using the traditional WACC
approach of enterprise
valuation, which uses a constant discount rate to value the
enterprise cash flows. While this
approach makes sense for valuing Corus prior to its acquisition,
the constant discount rate is
inconsistent with the projected changes in the firms capital
structure after Coruss
acquisition. A quick review of the debt ratios found in Figure
7-l indicates that the capital
structure weights (measured here in terms of book values) are
not constant over time for
either the status quo or growth strategy. In other words, the
use of a single discount rate is
problematic.
-
In situations in which the firms capital structure is expected
to substantially change
over time, we recommend that the Adjusted Present Value, or APV
approach, be used.
Introducing the APV Approach
The APV approach expresses enterprise value as the sum of the
following two components:
SavingsTax
Interest
the of Value
Flows Cash Free
Equity Unlevered
the of Value
Approach) (APV Value Enterprise (7.4)
The first component is the value of the firms operating cash
flows. Since the operating cash
flows are not affected by how the firm is financed, we refer to
these cash flows as the
unlevered equity free cash flows. The present value of the
unlevered equity free cash flows
represents the value of the firms cash flows under the
assumption that the firm is 100%
equity financed. The second component on the right hand side of
Equation 7.4 is the present
value of the interest tax savings associated with the firms use
of debt financing. The basic
premise of the APV approach is that debt financing provides a
tax benefit because of the
interest tax deduction.6 By decomposing firm value in this way,
the analyst is forced to deal
explicitly with how the financing choice influences enterprise
value.
Using the APV Approach to Value Corus under the Growth
Strategy
The APV approach is typically implemented using a procedure very
similar to what we did to
estimate the enterprise value using the traditional WACC
approach found in Equation 7.1 and
is described verbally in Equation 7.4a.
Value Terminal
Estimated the of
Value Present
SavingsTax
Interest
Period Planning
the of Value
Period Planning the for
Flows Cash Free
Equity Unlevered
the of Value
Approach) (APV Value Enterprise
(7.4a)
That is, we make detailed projections of cash flows for a finite
planning period and then
capture the value of all cash flows after the planning period in
a terminal value. The principal
difference between the APV and traditional WACC approaches is
that with the APV
approach we have two cash flow streams to value: the unlevered
equity cash flows and the
interest tax savings.
6 Technically, the second term can be an amalgam that captures
all potential side effects of
the firms financing decisions. In addition to the interest tax
savings, the firm may also
realize financing benefits that come in the form of below market
or subsidized financing. For
example, when one firm acquires assets or an operating division
from another, it is not
uncommon for the seller to help finance the purchase with a very
attractive loan rate.
-
Figure 7-2 summarizes the implementation of the APV approach in
three steps: First, we
estimate the value of the planning period cash flows in two
components: unlevered equity (or
operating) cash flows, and interest tax savings resulting from
the firms use of debt financing.
In step two we estimate the residual or terminal value of the
levered firm at the end of the
planning period, and finally, in Step 3, we sum the values of
the planning period cash flows
and the terminal value to estimate the enterprise value of the
firm.
Step 1: Estimate the value of the planning period cash flows
The planning period cash flows are comprised of both the
unlevered equity free cash flows
and the interest tax savings. We value these cash flows for
Corus using two separate
calculations. Equation (7.5) shows how we value the unlevered
equity cash flows for the
planning period (PP):
Flows Cash Free
PP
1tt
kUnlevered1
FFCFtEquity Unlevered
Period Planning
the of Value
(7.5)
Applying Equation 7.5 to the valuation of Coruss operating cash
flows for the planning
period (2007 - 2012) summarized in Table 7.4 for the growth
strategy case, we estimate a
value of 1929.15 million:
654
321
.0927 1
924.14
.0927 1
760.83
.0927 1
577.46
.0927 1
324.98
.0927 1
206.37
.0927 1
77.37 Flows Cash FreeEquity edtheUnlever of Value
This valuation is based on an estimate of the unlevered cost of
equity equal to 9.27%. We
estimate the unlevered cost of equity in Figure 7-3 using the
procedure described in Table 4-1
of Chapter 4 where we estimated the firms WACC and again in
Chapter 5 to estimate a
projects cost of capital. The estimated unlevered beta for Corus
is .849, which when
combined with a 10-year government security yield of 4.60% and a
5.50% market risk
premium, generates an unlevered cost of equity of 9.27%.
Next we calculate the value of the interest tax savings for the
planning period as
follows:
SavingsTax Interest
PP
1 ttr1
Rate Tax X Expense Interest Period Planning
the of Value
t
where r is the firms borrowing rate. Substituting Coruss
interest tax savings for the growth
strategy (found in Table 7-4) into Equation 7.6 produces a
519.66 million estimate for the
value of its planning period interest tax savings.
-
5 Note that we are holding everything constant except the
savings in cost in this analysis. For
instance, the growth rate in sales is still assumed to be 5% and
the discount rate is still
assumed to be 8.420%.
Using the Adjusted Present Value (APV) Model to Estimate
Enterprise
Step 1: Estimate the Value of the planning period cash flows
Evaluation of Operating (unlevered) Cash Flows
Definition: Unlevered
Equity Free Cash
Flows = Firm or
Project Free Cash
Flows
Formula:-
Net Operating
Income
Less: Taxes
Net Operating Profit
After Taxes
(NOPAT)
Plus: Depreciation
Expense
Less: Capital
Expenditures (Capex)
Less: Increases in Net
Working Capital
Equals Unlevered
Equity Free Cash
Flows (=FFCF)
Flows Cash
Equity Unlevered
)k(1
FFCF1 Period Planning of Value
PP
1t1
unlevered
FFCF1 = Firm Free Cash Flow (equals equity free cash flow for
the
unlevered firm)
Kunlevered = Discount rate for project cash flows (unlevered
equity)
PP = Planning Period
Evaluation of the Interest Tax Savings
Definition : Interest
Tax Savings
Formulas:-
Interest tax savings in
year t = Interest
Expense in year t x
Tax Rate
)r(1
Rate Tax x Expense Intertest SavingsTax Interest the of
Value
PP
1t1
PP = Planning Period
r = firms borrowing rate
Step 2: Estimate the value of the levered firm at the end of the
planning period (i.e., the
-
terminal value)
Evaluation of the Terminal Value
Definition: Terminal
Value of firm is equal
to the enterprise value
of the levered firm at
the end of the planning
period
Assumptions:- After
the planning period the
firm maintains a
constant proportion.1.
of debt in its capital
structure. The firms
cash flows grow at a
constant rate g which
is less than the firms
weighted average cost
of capital forever.
Formulas:-
gkwacc
g)FFCFpp(1FirmPP Levered the of Value Terminal
FFCFpp = firm free cash flow for the end of the planning
period
Kwacc = weighted average cost of capital
g = rate of growth in FFCF after the end of the playing period
in
perpetuity
Step 3 : Sum the estimated values for the planning period and
terminal period cash flows
pp
dkunleverre1
1g
k
g)(1FFCF
pp
1t
pp
1t 1r)(1
Rate Tax xExpense Interest
1)K(1
FFCFValue Enterprise of model APV
wacc
pp
unlevered
1
Step 1 : Value of Planning Period Cash Flows Step 2: Value of
the Terminal Period cash
Flows
Figure 7-3
Coruss Cost of Capital Assumptions:
Assumptions:
1. The risk free rate is 4.60%.
2. The market risk premium is 5.50%. (Source: Elroy Dimson, Paul
Marsh, and Mike
Staunton, Global Evidence on the Equity Risk Premium, Journal of
Applied
Corporate Finance 15 (Fall 2003), pp. 27-38.)
-
3. The corporate tax rate is 30%.
4. The asset beta (or unlevered equity beta) is 0.849.
5. Under the status quo strategy, the target capital structure
is given by a debt to
enterprise value ratio of 22% and the cost of debt is 6%.
6. Under the growth strategy, the target capital structure is
given by a debt to enterprise
value ratio of 35% and the cost of debt is 8%.
Step 1. Compute unlevered cost of equity: Substitute the
unlevered equity beta into the
CAPM to estimate the unlevered cost of equity for the subject
firm. Given a risk free
rate of 4.60% and a market risk premium of 5.50%, we get an
estimated cost of equity
for an unlevered investment of 9.27%, i.e.,
Kunlevered equity = Risk-free rate + unlevered (Market-risk
premium)
Kunlevered equity = .0460 + .849 x .0550 = .09727 or 9.27%
Step 2. Compute levered cost of equity and weighted average cost
of capital: *Relever the
asset beta of 0.849 using the following equation**for levering
and unlevering betas. For the
status quo case, the relevering is based on a target capital
structure (debt to enterprise value
ratio of 22%) and a cost of debt of 6%. For the growth case, the
debt to enterprise value
ratio is 35% and the cost of debt is 8%.
debt L
r1
rTX1 - L
r1
rTX11
unlevered
levered
(7.7)
where unlevered, levered, and debt are the betas for the firms
unlevered and levered equity, plus
its debt. The cost of debt is r. T is the corporate tax rate,
and L is the debt to equity ratio.
Finally, one can find the weighted average cost of capital
as
eKL1
LT1rL
L1
LWACCk
Status Quo Strategy Growth Strategy
levered equity beta
levered cost of equity (CAPM)
WACC
1.02
10189%
8.857%
0.97
9.938%
8.857%
* The weighted average cost of capital and the levered cost of
equity can also be related to the
unlevered cost of equity capital by using the following
relationships (L denotes the debt to
equity ratio, r is the cost of debt):
Lr1
rT1r
unleveredk
unleveredk
ek and
r1
unleveredk1
L1
LrT
unleveredk
WACCk
-
** This relationship captures the effects of financial leverage
on the firms beta coefficient. It
is a more general version of a similar formula discussed in
Chapter 4 and Chapter 5. It
applies in the setting where the firm faces uncertain perpetual
cash flows, corporate are taxed,
corporate debt is risky (i.e., debt betas are greater than
zero), and the firms use of financial
leverage (i.e., the debt to equity ratio, L) is reset to a
constant level every period. For a
derivation of this equation see E. Arzac and L. Glosten, A
Reconsideration of Tax Shield
Valuation, Unpublished Manuscript, 2004.
Coruss Operating and Financial Cash Flows for the Planning
Period
[All figures in millions]
Panel a. Unlevered Equity Free Cash Flows (same as FFCF)
Unlevered Equity Free Cash Flows 2007 2008 2009 2010 2011
2012
Status Quo Case 276.67 339.94 351.04 414.97 426.74 438.87
Growth Strategy Case 77.37 206.37 324.98 577.46 760.83
924.14
Panel b. Interest Tax Savings
Interest Tax Savings 2007 2008 2009 2010 2011 2012
Status Quo Case 32.26 29.56 25.57 21.26 15.70 9.74
Growth Strategy Case 108.63 114.20 117.18 117.71 112.60
103.14
519.66
.08 1
103.14
.08 1
112.60
.08 1
117.71
.08 1
117.18
.08 1
114.20
.08 1
108.63 SavingsTax Interest Period gthePlannin of Value
654
321
The combined value of operating cash flows and interest tax
savings for the planning period
under the growth strategy, then, is 2448.81 million ( = 1929.15
+ 519.66).
Step 2: Estimate Coruss Term of Value
The terminal value calculation for the APV approach is identical
to the calculation we made
for our WACC analysis. As we previously stated, at the terminal
date. Coruss cash flows
are assumed to grow at a constant rate of 2% per year and its
capital structure will revert to a
constant mix of debt and equity such that the debt to value
ratio would be 35%. Therefore,
we can use the Gordon Growth Model to estimate the terminal
value of the levered firm at the
end of the planning period (pp) as follows:
gkWACC
g)FFCFpp(1ppFirm Levered the of Value Terminal
(7.7)
-
Coruss FFCFpp in 2012 (which is the end of the planning period)
is equal 924.14 (see Table
7-4) and this FFCF is expected to grow at a rate of 2% in
perpetuity, and the weighted
average cost of capital (kwacc) is 8.420%.7 Using Equation 7.7
we estimate the terminal value
for Corus in 2012 as follows:
14683.50.02.0842
1.02 924.142012
Firm Levered the
of Value Terminal
We have one remaining calculation to make in order to value
Coruss terminal value.
We need to discount the terminal value estimated in Equation 7.7
back to the present using
the unlevered cost of equity, i.e.,
$8626.506.09271
1
.02.0842
.02 1 924.14Value Terminal
the of Value Present
2006
To complete the valuation of Corus using the APV method we now
sum the value of the
planning period and terminal value in the final step.
Step 3. Summing the Values of the Planning Period and Terminal
Period
Using the APV approach we estimate the enterprise value of the
firm as the following sum:
pp
Unleveredwacc
PP
PP
1tt
tPP
1tt
Unlevered
k1
1
gK
g1FFCF
r1
Rate Tax X Expense Interest
k1
FFCF1Approach) (APV Value Enterprise
Step 1: Value of Planning Period Cash Flows
Step 2 :Value of the Terminal Period Cash Flows (7.4a)
Substituting for the two components, we estimate Coruss
enterprise value using the APV
model to be 11,075.31 million, i.e.,
Enterprise Value (APV Approach) = 1929.15 + 519.66 + 8626.50 =
11,075.31
This estimate is very nearly equal to the estimates of Coruss
enterprise value found in Panel
c of Table 7-3 using the traditional WACC model (at 11037
million). However, for those
cases where the capital structure of the firm is expected to
change dramatically over the
planning period, the APV model provides a preferred method for
estimating enterprise value.
7 The weighted average cost of capital can also be related to
the unlevered cost of equity
capital by using the following relationship:
-
20%.0842or8.4.081
.09271X
.351
.35.08X.30X0947
WACCk
r1
Unleveredk1
L1
LTaxRate
dr
Unleveredk
WACCk
Where L is the ratio of debt to equity ratio.
Using an EBITDA Multiple to Calculate the Terminal Value
Using preceding application of the APV approach to the
estimation of Coruss enterprise
value used the discounted cash flow (DCF) approach to value both
the planning period value
and the post planning period terminal value. What typically
happens in practice, however, is
that a market-based multiple is used to estimate the value of
the post-planning period cash
flows. Equation 7.4b defines the APV approach of enterprise
value as the sum of the present
values of the planning period cash flows (i.e., both the
unlevered cash flows of the firm8 and
the interest tax savings) plus the terminal value of the firm
which is estimated using the
EBITDA multiple,.
The values of the two planning period cash flow streams for
Corus under the Growth Strategy
were estimated earlier in Table 7-4, and equal 924.15 for the
operating cash flows and
519.66 for the interest tax savings. Using the 6.70 times
multiple of EBITDA from our
previous analysis and the estimated EBITDA for 2012 (found in
Table 7-3), we calculate
Coruss terminal value cash flow as follows:
EBITDA for 2012 is found in Table 7-3 by summing the 1822.59
million EBITDA from
operations, with the 58.00 million from other income to get
1880.59 million. Multiplying
this EBITDA estimate by 6.70 produces an estimate of the
terminal value in 2012 of
12599.95 million. Discounting the terminal value back to the
present using the unlevered
cost of equity we get 7402.44. To complete the estimate of
enterprise value using the hybrid
APV we simply substitute our estimates of the values of the cash
flow streams into Equation
7.4b as follows:
This value is slightly lower than our earlier estimate because
in this case the EBITDA
multiple provided a more conservative estimate of Coruss
terminal value.
Table 7-5 summarizes the APV estimates of enterprise value for
the status quo and growth
strategies using our two methods for estimating terminal
value.
8 Recall from Chapter 2 that the unlevered cash flows of a firm
are simply the cash flows that
the firm would realize if it uses no debt financing.
Furthermore, these unlevered cash flows
are the same as the firm free cash flows (FFCF) calculated
earlier to value the firm using the
traditional WACC model. However, in the APV model we discount
the FFCFs using the
unlevered cost of equity capital (i.e., the equity discount rate
appropriate for a firm that uses
no debt financing) and then account for the value of the firms
interest tax savings as a
separate present value calculation.
Table 7-5
-
APV Valuation Summary for Corus for Status Quo and Growth
Strategies [All Figure in
Millions]
Panel a. Status Quo Case
APV Estimate of Enterprise Value
APV Calculation
of Planning
Period Cash
Flow
DCF Estimates of
Terminal Value
Total
Unlevered equity free cash
flow
1,629.85 3,557.38 5,187.23
Interest Tax Savings 113.75 113.75
Total 1,743.60 3,557.38 5,300.98
Hybrid APV Estimate of
Enterprise Value
APV Calculation
of Planning
Period Cash
Flow
EBITDA Multiple
Terminal Value
Total
Unlevered equity free cash
flow
1,629.85 3,957.11 5,586.96
Interest Tax Savings 113.75 113.75
Total 1,743.60 3,957.11 5,700.71
Hybrid APV Estimate of
Enterprise Value
Panel b. Growth Strategy Case
APV Estimate of Enterprise Value
APV Calculation
of Planning
Period Cash
Flow
DCF Estimates of
Terminal Value
Total
Unlevered Equity free cash
flow
1,929.15 8,626.50 10,555.65
Interest Tax Savings 519.66 519.66
-
Total 2,448.81 8,626.50 11,075.31
Hybrid APV Estimate of Enterprise Value
APV Calculation
of Planning
Period Cash
Flow
EBITDA Multiple
Terminal Value
Total
Unlevered Equity free cash
flow
1,929.15 7,402.44 9,331.59
Interest Tax Savings 519.66 519.66
Total 2,448.81 7,402.44 9,851.25
Comparing the WACC and APV Estimates of Coruss Enterprise
Value
Table 7-6 combines our estimates of Coruss enterprise value
using both the traditional
WACC approach and the APV approach. Although the estimates are
not exactly the same,
they are surprisingly similar. The growth strategy clearly
dominates the status quo strategy.
Also, the acquisition price of 6172.31 million cannot be
justified under the status quo
strategy. It is only under the growth strategy that such a high
acquisition price can be
acceptable.
Summary of WACC and APV Estimates f Corus's
Enterprise Value [All figures in millions]
Status quo strategy Traditional WACC APV
Terminal Value
* Gordon Growth Model
* EBITDA Multiple
5,290.76
5,699.67
5,300.98
5,700.71
Growth strategy Traditional WACC APV
Terminal Value
* Gordon Growth Model
* EBITDA Multiple
11,036.92
9,754.15
11,075.31
9,851.25
In this particular application of the WACC and APV valuation
approaches the results are for
all practical purposes the same. In practice, the capital
structure changes much more
dramatically in an LBO transaction because debt levels have to
be brought down within a
short span of time. Even in the Tata-Corus transaction, the
final terms of loan agreements
mandated that about a third of the debt amount should be paid
back on an annual amortized
basis within five years. The effects caused by very dramatic
changes in debt financing over
the life of the investment can lead to meaningful differences in
the results of the two
-
valuation approaches. and in these instances the APV approach
has a clear advantage in that
it can more easily accommodate the effects of changing capital
structure.
The EBTTDA multiple used in the valuation of Corus produced
results that were very similar
to the DCF estimate and this is purely an artifact of the
particular choices made in carrying
out this valuation. Due to the importance of the terminal value
to the overall estimate of
enterprise value we recommend that both approaches be used and
that when selecting an
EBITDA multiple. close attention be paid to recent transactions
involving closely comparable
firms. The advantage of the EBITDA multiple in this setting is
that it ties the analysis of more
distant cash flows back to a recent market transaction. However,
the EBITDA multiple
estimate or terminal value should be compared to a DCF estimate
using the analysts
estimates of reasonable growth rates as a test or the
reasonableness of the terminal value
estimate based on multiples.
A Brief Summary of the WACC and APV Valuation Approaches
The following grid provides a summary of the salient features of
the traditional WACC and
APV approaches. As we have discussed, the traditional WACC
method is the approach that
is used in practice. However, when the capital structure of the
firm being valued is likely to
be changing over time the APV is the preferred approach.
Adjusted Present Value
(APV Method
Traditional WACC Method
Object of the
Analysis
Enterprise value as the sum
of the values of:
The unlevered equity cash flows, and
Financing side effects
Enterprise value equal to the
present value of the firm's
capital cash flows discounted
using the after-tax WACC
Cash Flow
calculation
Unlevered equity free cash flows (i.e. firm free
cash flows), plus
Interest tax savings
Firm free cash flows (FFCF)
Discount Rate(s) Unlevered equity cash flows-cost of equity
for
unlevered firm, and
Interest tax savings-the yield to maturity on the
firm's debt
After tax weighted average
cost of capital (WACC)
How Capital Structure
Effects Are Dealt with-
Discount Rates, Cash
Flows, or Both
Cash flows Capital
structural affects the present
value of the interest tax
savings o